THE Statement of Cash Flow-1 (1)

Questions on Firm Profitability and Bankruptcy

• Is it possible for a firm to be highly profitable and go bankrupt?

  • Yes, profitability does not guarantee liquidity. Factors like poor cash management, high liabilities, or external economic conditions can lead to bankruptcy despite high earnings.

• Is it possible for a firm to be highly unprofitable and stay in business?

  • Yes, a firm may persist due to factors such as access to external funding, asset sales, or strategic restructuring, allowing it to survive even while operating at a loss.

Importance of the Statement of Cash Flows

• Cash vs. Net Income:

  • Positive net income on the income statement is insignificant unless it translates into cash.

  • The Statement of Cash Flows provides insights into how cash is generated from operations.

Requirements of the Statement of Cash Flows

• Required by SFAS #95, replacing the Statement of Changes in Financial Position in 1988.

• Developed from two consecutive balance sheets and the current year's income statement.

Primary Objectives

• Calculation Methods:

  • Understand how to calculate cash flow using both indirect and direct methods.

  • Interpret the accounting information in the Statement of Cash Flows.

Core Components of the Statement of Cash Flows

• Cash Inflows and Outflows by Activity Type:

  • Information is categorized into three activities:

    • Operating Activities: Core business operations.

    • Investing Activities: Purchase/sale of long-term assets.

    • Financing Activities: Cash transactions with creditors and investors.

Understanding Net Cash Flows

• Abbreviations:

  • CFO: Net cash flow from operating activities.

  • CFI: Net cash flow from investing activities.

  • CFF: Net cash flow from financing activities.

  • Equation: CFO + CFI + CFF = Net change in cash for the year.

Overview of Cash Flow Calculation

• Total cash flow during an accounting period:

  • Total Inflows - Total Outflows = Change in cash.

  • Indicates company liquidity.

Conceptual Format for the Statement

• Example format for financial presentation, including inflows and outflows categorized under operating, investing, and financing activities.

  • Example provided has sections for cash flows, net cash used, and cash equivalents.

Interpreting the Statement of Cash Flows - Operating Activities

• Key Components:

  • Production and delivery of goods and services.

  • Purchase/sale of inventories and payment for operating expenses.

  • Collection of accounts receivable impacts cash flow.

Investing Activities Description

• Involves:

  • Purchase/sale of marketable securities and long-term investments.

  • Purchase/sale of productive assets.

  • Lending money and collecting on loans.

Financing Activities Breakdown

• Involves:

  • Borrowing from creditors or repaying principal.

  • Sale or repurchase of stock.

  • Dividends paid to shareholders.

Impact of Balance Sheet on Cash Flow Statement

• Calculating Balance Changes:

  • Step 1: Calculate the change in each balance sheet account (Δ).

  • Step 2: Use the balance sheet equation to solve for change in cash (ΔCash).

Balance Sheet Equation Review

• Assets = Liabilities + Equity

• Changes in asset accounts inversely affect cash flow; changes in liabilities/equity have a direct correlation to cash flow.

Summarizing Changes in Balance Sheet

• Sources and Uses:

  • Decreases in assets are sources of cash; increases are uses.

  • Conversely, increases in liabilities/equity are sources; decreases are uses.

Steps for Cash Flow Statement Preparation

• Step 3: Transfer sources or uses to the appropriate areas in the cash flow statement, referencing templates from textbooks.

Differences in U.S. GAAP vs. IFRS

• Classifications for interest and dividends vary:

  • CFO or CFI for interest/dividends received under IFRS, typically CFO under U.S. GAAP.

  • CFO for taxes paid in both frameworks.

Net Income Placement on Cash Flow Statement

• Retained earnings on the balance sheet reflect the difference between net income and dividends.

  • Transactions affecting net income are considered operating activities.

Methods for Presenting Cash Flow

• Indirect Method: Shows net income followed by non-cash adjustments.

• Direct Method: Displays individual cash transactions that determine net income.

  • Both methods yield identical cash flow figures but differ in the presentation of cash from operations (CFO).

Summarizing Cash Flow Calculation

• Regardless of method, total cash flows from all activities lead to changes in cash.

  • Change in cash + beginning cash = ending cash.

Direct Method Recommendations

• Both U.S. GAAP and IFRS recommend using this method for operating cash flow. Under U.S. GAAP, a reconciliation document is required.

Indirect Method Overview

• Starts with net income; adjustments for revenues and expenses are made based on the timing of cash flows.

  • Gain/loss adjustments necessary to avoid double-counting cash flow effects.

Noncash Adjustments on CFO

• Sources (added back to net income):

  • Depreciation, non-operating asset losses.

• Uses (subtracted from net income):

  • Gains on asset sales or excess tax benefits.

Effects of Gains/Losses on Cash Flow

• Gain from asset sale reduces net income but is a source of cash, so it must be adjusted in CFO.

• Losses increase net income, affecting cash flow adjustments.

Handling Cash Flow Using Direct Method

• Derives cash flow from sales, adjusting for changes in working capital accounts.

• Non-cash items do not appear directly in this method.

Working Capital Considerations

• Current assets minus current liabilities = net working capital.

• Changes in working capital are considered sources or uses of cash depending on increases or decreases.

Trends in Cash Flow Analysis

• Favorable Trends: Persistent net income growth, positive operating cash flows, and sufficient cash flow for investments.

• Unfavorable Trends: Negative net income and cash flows insufficient to cover investments or repayments.

Cash Flow Adequacy and Free Cash Flow

• Cash Flow Adequacy Ratio = CFO / CapEx. A higher ratio is usually better.

• Free Cash Flow (FCF) calculation: Cash from operations - Capital expenditures.

Red Flags in Cash Flow Analysis

• Negative income with positive operating cash flow due to depreciation.

• Shifting cash outflows to boost operating cash flow can indicate financial mismanagement.

Life-Cycle Approach on Cash Flow

• Stages:

  • Introduction: High costs, negative cash flows; relies on financing.

  • Growth: Profitable operations; external financing diminishes.

  • Maturity: High net cash flow; external financing is minimized.

  • Decline: Declining cash flow; potential asset divestiture.